PROFIT MAXIMIZATION VS. STOCKHOLDER WEALTH MAXIMIZATION

Profit maximization is basically is a single-period or, at most, a short-term goal, to be achieved within one year; it is usually interpreted to mean the maximization of profits within a given period of time. A corporation may maximize its short-term profits at the expense of its long-term profitability. In contrast, stockholder wealth maximization is a long-term goal, since stockholders are interested in future as well as present profits.

Wealth maximization is generally preferred because it considers (1) wealth for the long term, (2) risk or uncertainty, (3) the timing of returns, and (4) the stockholders` return. Timing of returns is important; the earlier the return is received, the better, since a quick return reduces the uncertainty about receiving the return, and the money received can be reinvested sooner. Table 1-1 summarizes the advantages and disadvantages of these two often conflicting goals.

TABLE 1-1

PROFIT MAXIMIZATION VERSUS STOCKHOLDER WEALTH MAXIMIZATION

Goal

Objective

Advantages

Dis advantages

Profit maximi zation

Large profits

1. Easy to calculate profits.
2. Easy to determine the link between financial decisions and profits.

1. Emphasizes the short-term.
2. Ignores risk or uncertainty.
3. Ignores the timing of returns.
4. Requires immediate resources.

Stock holder wealth maximi zation

Highest share price of common stock

1. Emphasizes the long term.
2. Recognizes risk or uncertainty.
3. Recognizes the timing of returns.
4. Considers stockholders` return.
1. Offers no clear relationship between financial decisions and stock price.
2. Can lead to management anxiety and frustration.
3. Can promote aggressive and creative accounting practices.

Note: The policy decisions that by themselves are likely to affect the value of the firm (maximize stockholder wealth) include the:

  • Investment in a project with a large net present value.
  • Sale of a risky division that will now increase the credit rating of the entire company.
  • Use of a more highly leveraged capital structure that resulted in lower cost of capital.

Let us now see how profit maximization may affect wealth maximization.

EXAMPLE 1-1

Profit maximization can be achieved in the short-term at the expense of the long-term goal of wealth maximization. For example, a costly investment may create losses in the short-term but yield substantial profits in the long term; a company that wants to show a short-term profit may postpone major repairs or replacement even though such postponement is likely to hurt its long-term profitability.

EXAMPLE 1-2

Profit maximization, unlike wealth maximization, does not consider risk or uncertainty. Consider two products, A and B, and their projected earnings over the next five years, as shown below.

Year

Product A

Product B

1

$20,000

$22,000

2

$20,000

$22,000

3

$20,000

$22,000

4

$20,000

$22,000

5

$20,000

$22,000

$100,000

$110,000

A profit maximization approach favors product B over product A because its totals projected earnings after five years are higher. However, if product B is more risky than product A, then the decision is not as straightforward as the figures seem to indicate because of the trade-off between risk and return. Stockholders expect greater returns from investments with higher risk; they will demand a sufficiently large return to compensate for the comparatively greater level of risk of producing product B.

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